A price to earnings ratio, otherwise known as a P/E ratio, is a quick calculation used to evaluate how expensive, or cheap, the stock market may be at any given time. Just as an appraiser can come out and give you an estimate of the value of your home, the P/E ratio is a tool you can use to estimate the fair value of the stock market.
It is also a metric used to help compare similar stocks to one another. By similar I mean stocks of companies in the same industry or who produce the same type of product or service. It is not as useful when comparing stocks across different industries, as some industries are known to have much higher P/E ratios than other industries.
How Is A P/E Ratio Calculated?
In simple terms, a P/E ratio is the price (P) divided by earnings (E). A stock with a price of $10 a share, and earnings last year of $1 a share, would have a P/E ratio of 10.
In more complex terms, you have to decide whether to look at P/E ratios based on last year’s earnings, a future forecast of earnings, or a ten year average of past earnings. In addition, P/E ratios for an individual stock must be interpreted much differently than P/E ratios for the market as a whole.
To learn more about P/E ratios, read: